UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 1-10777
Ambac Financial Group, Inc. (Exact name of Registrant as specified in its charter)
Delaware
13-3621676
(State of incorporation)
(I.R.S. employer identification no.)
One State Street Plaza New York, New York
10004
(Address of principal executive offices)
(Zip code)
(212) 668-0340 (Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x
No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
As of July 31, 2003, 106,728,397 shares of Common Stock, par value $0.01 per share, (net of 0 treasury shares) of the Registrant were outstanding.
Ambac Financial Group, Inc. and Subsidiaries
INDEX
PAGE
PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets – June 30, 2003 and December 31, 2002
3
Consolidated Statements of Operations – three and six months ended June 30, 2003 and 2002
4
Consolidated Statements of Stockholders’ Equity – six months ended June 30, 2003 and 2002
5
Consolidated Statements of Cash Flows – six months ended June 30, 2003 and 2002
6
Notes to Consolidated Financial Statements
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
14
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
33
Item 4.
Controls and Procedures
34
PART II
OTHER INFORMATION
Submission of Matters to a Vote of Security Holders
35
Item 6.
Exhibits and Reports on Form 8-K
SIGNATURES
37
INDEX TO EXHIBITS
38
2
PART 1 - FINANCIAL INFORMATIONItem 1 - Financial Statements of Ambac Financial Group, Inc. and Subsidiaries
Ambac Financial Group, Inc. and SubsidiariesConsolidated Balance Sheets June 30, 2003 and December 31, 2002 (Dollars in Thousands)
June 30, 2003
December 31, 2002
(unaudited)
Assets
Investments:
Fixed income securities, at fair value (amortized cost of $12,232,867 in 2003 and $11,132,149 in 2002)
$
12,885,401
11,597,623
Fixed income securities pledged as collateral, at fair value (amortized cost of $519,199 in 2003 and $537,711 in 2002)
518,606
543,572
Short-term investments, at cost (approximates fair value)
389,145
395,761
Other, at fair value (cost of $4,517 in 2003 and $3,518 in 2002)
3,797
2,354
Total investments
13,796,949
12,539,310
Cash
26,980
25,816
Securities purchased under agreements to resell
179,608
260,818
Receivable for investment agreements
80,867
169
Receivable for securities sold
67
6,936
Investment income due and accrued
141,911
142,406
Reinsurance recoverable on paid and unpaid losses
3,944
4,842
Prepaid reinsurance
314,866
296,126
Deferred acquisition costs
174,646
174,055
Loans
820,447
843,809
Derivative product assets
1,210,181
1,010,081
Other assets
46,833
51,170
Total assets
16,797,299
15,355,538
Liabilities and Stockholders’ Equity
Liabilities:
Unearned premiums
2,371,250
2,128,847
Losses and loss adjustment expense reserve
181,772
172,137
Ceded reinsurance balances payable
15,034
16,930
Obligations under investment and payment agreements
6,591,813
6,434,497
Obligations under investment repurchase agreements
715,405
848,358
Securities sold under agreement to repurchase
140,390
132,235
Deferred income taxes
248,420
185,641
Current income taxes
25,472
44,807
Debentures
791,748
616,715
Accrued interest payable
67,415
81,252
Derivative product liabilities
1,010,839
836,146
Other liabilities
148,614
154,640
Payable for securities purchased
447,625
78,154
Total liabilities
12,755,797
11,730,359
Stockholders’ equity:
Preferred stock
—
Common stock
1,067
1,062
Additional paid-in capital
573,797
550,289
Accumulated other comprehensive income
378,273
265,427
Retained earnings
3,088,365
2,820,281
Common stock held in treasury at cost
(11,880
)
Total stockholders’ equity
4,041,502
3,625,179
Total liabilities and stockholders’ equity
See accompanying Notes to Consolidated Financial Statements
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Operations (Unaudited) For the Periods Ended June 30, 2003 and 2002 (Dollars in Thousands Except Share Data)
Three Months EndedJune 30,
Six Months EndedJune 30,
2003
2002
Revenues:
Financial Guarantee:
Gross premiums written
386,005
195,683
583,224
345,044
Ceded premiums written
(42,313
(24,705
(73,481
(44,254
Net premiums written
343,692
170,978
509,743
300,790
Net premiums earned
151,992
113,630
286,744
217,284
Other credit enhancement fees
12,294
6,576
22,658
12,864
Net premiums earned and other credit enhancement fees
164,286
120,206
309,402
230,148
Net investment income
79,892
73,593
156,487
146,140
Net realized investment gains
12,777
3,472
26,720
2,972
Net mark-to-market gains (losses) on credit derivative contracts
10,002
(7,982
(2,174
(12,053
Other income
1,931
800
2,756
2,114
Financial Services:
Interest from investment and payment agreements
55,476
67,618
114,472
127,609
Other revenue
(6,179
4,731
2,338
15,447
4,641
393
4,949
584
Net mark-to-market gains on derivative hedge contracts
51
15
728
182
Corporate:
2,108
956
3,039
1,685
Net realized investment losses
(444
Total revenues
324,985
263,358
618,717
514,384
Expenses:
Losses and loss adjustment expenses
10,900
5,900
20,700
11,600
Underwriting and operating expenses
21,013
18,603
43,179
37,164
50,160
61,383
103,592
115,499
Other expenses
6,234
5,699
12,392
10,835
Interest
14,537
10,816
26,991
21,482
Corporate
2,227
2,015
10,500
3,481
Total expenses
105,071
104,416
217,354
200,061
Income before income taxes
219,914
158,942
401,363
314,323
Provision for income taxes
57,343
39,181
100,869
77,610
Net income
162,571
119,761
300,494
236,713
Net income per share:
Basic
1.53
1.13
2.83
2.23
Diluted
1.48
1.09
2.75
2.17
Weighted average number of common shares outstanding:
106,428,045
106,124,220
106,246,887
105,978,049
109,417,451
109,515,722
109,005,885
109,260,209
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Stockholders’ Equity (Unaudited) For The Six Months Ended June 30, 2003 and 2002 (Dollars in Thousands)
Retained Earnings:
Balance at January 1
2,403,473
Dividends declared - common stock
(21,231
(19,064
Exercise of stock options
(11,179
30,920
Balance at June 30
2,652,042
Accumulated Other Comprehensive Income:
62,476
Unrealized gains on securities, $175,726 and $150,806, pre-tax in 2003 and 2002, respectively(1)
111,634
95,186
Gain on derivative hedges
677
21
Foreign currency translation gain
535
1,063
Other comprehensive income
112,846
96,270
Comprehensive income
413,340
332,983
158,746
Preferred Stock:
Balance at January 1 and June 30
Common Stock:
1,060
Issuance of stock
Additional Paid-in Capital:
538,135
Employee benefit plans
14,489
12,859
11,490
4,282
Capital issuance costs
(2,471
(5,767
549,509
Common Stock Held in Treasury at Cost:
(21,456
Cost of shares acquired
(23,835
(15,829
Shares issued under equity plans
35,715
37,127
0
(158
Total Stockholders’ Equity at June 30
3,361,201
(1) Disclosure of reclassification amount:
Unrealized holding gains arising during period
135,559
95,897
Less: reclassification adjustment for net gains included in net income
23,925
711
Net unrealized gains on securities
See accompanying Notes to Consolidated Financial Statements.
Ambac Financial Group, Inc. and SubsidiariesConsolidated Statements of Cash Flows (Unaudited) For The Six Months Ended June 30, 2003 and 2002 (Dollars in Thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
1,614
1,724
Amortization of bond premium and discount
6,915
1,720
(19,335
(79,395
(1,767
4,503
(591
(6,868
Unearned premiums, net
223,663
84,096
10,533
9,510
(1,896
(315
495
(11,670
(13,837
(5,595
(31,669
(3,112
Net unrealized losses on credit derivative contracts and derivative hedge contracts
1,446
11,871
Other, net
32,724
(32,298
Net cash provided by operating activities
508,789
210,884
Cash flows from investing activities:
Proceeds from sales of bonds
1,604,622
791,622
Proceeds from matured bonds
1,570,333
1,078,238
Purchases of bonds
(3,849,511
(3,167,562
Change in short-term investments
6,616
194,576
81,210
(2,805
23,362
(31,019
(8,644
(1,686
Net cash used in investing activities
(572,012
(1,138,636
Cash flows from financing activities:
Dividends paid
Securities sold under agreements to repurchase
8,092
(16,000
Proceeds from issuance of investment and payment agreements
956,327
1,847,169
Payments for investment and payment agreement draws
(1,062,892
(943,617
Proceeds from issuance of debentures
363,188
Payment for buyback of debentures
(200,000
Issuance of common stock
11,494
4,284
Proceeds from sale of treasury stock
Purchases of treasury stock
Net cash provided by financing activities
64,387
888,303
Net cash flow
1,164
(39,449
Cash and cash pledged as collateral at January 1
76,580
Cash and cash pledged as collateral at June 30
37,131
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes
100,000
112,500
Interest expense on debt
26,840
17,647
Interest expense on investment agreements
101,447
114,631
Ambac Financial Group, Inc. and SubsidiariesNotes to Consolidated Financial Statements
(1) Basis of Presentation
Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and other financial services to clients in both the public and private sectors around the world. Ambac provides financial guarantees for public finance and structured finance obligations through its principal operating subsidiary, Ambac Assurance Corporation. Through its financial services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate, currency and total return swaps, funding conduits, and investment advisory and cash management services.
Ambac Assurance has earned triple-A ratings, the highest ratings available from Moody’s Investors Service, Inc., Standard & Poor’s Ratings Services, Fitch, Inc. and Rating and Investment Information, Inc. These ratings are an essential part of Ambac Assurance’s ability to provide financial guarantees.
Ambac’s consolidated unaudited interim financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (“GAAP”) and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of Ambac’s financial condition, results of operations and cash flows for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the three and six months ended June 30, 2003 may not be indicative of the results that may be expected for the full year ending December 31, 2003. These consolidated financial statements and notes should be read in conjunction with the financial statements and notes included in the consolidated financial statements of Ambac Financial Group, Inc. and its subsidiaries contained in (i) Ambac’s Annual Report on Form 10-K for the year ended December 31, 2002, which was filed with the Securities and Exchange Commission on March 28, 2003, and (ii) Ambac’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2003, which was filed with the SEC on May 15, 2003.
The consolidated financial statements include the accounts of Ambac and each of its subsidiaries. All significant intercompany balances have been eliminated.
Certain reclassifications have been made to prior period’s amounts to conform to the current period’s presentation.
(2) Segment Information
Ambac has two reportable segments, as follows: (1) financial guarantee, which provides financial guarantee products (including structured credit derivatives); and (2) financial services, which provides investment agreements, interest rate swaps, total return swaps, funding conduits, and investment advisory and cash management services. Ambac’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different marketing strategies, personnel skill sets and technology.
Pursuant to insurance and indemnity agreements, Ambac Assurance guarantees the swap and investment agreement obligations of those financial services subsidiaries. Intersegment
Notes to Consolidated Financial Statements (Continued)
revenues include the premiums earned under those agreements, but which are eliminated in the consolidated financial statements. Such premiums are accounted for as if they were premiums to third parties, that is, at current market prices.
Information provided below for “Corporate and Other” relates to Ambac Financial Group, Inc. corporate activities. Corporate and other revenue from unaffiliated customers consists primarily of interest income. Intersegment revenues consist of dividends received.
The following tables summarize the financial information by reportable segment as of and for the three and six-month periods ended June 30, 2003 and 2002:
(Dollars in thousands) Three months ended June 30,
Financial Guarantee
Financial Services
Corporate And Other
Intersegment Eliminations
Consolidated
2003:
Unaffiliated customers
268,888
53,989
Intersegment
1,218
(1,113
22,400
(22,505
270,106
52,876
24,508
Income before income taxes:
236,975
(2,405
(14,656
1,754
(660
21,974
(23,068
Total income before income taxes
238,729
(3,065
7,318
Identifiable assets
7,787,223
8,822,514
187,562
2002:
190,089
72,757
512
3,954
(936
23,000
(26,018
194,043
71,821
23,512
165,586
5,675
(12,319
4,168
(1,019
22,673
(25,822
169,754
4,656
10,354
6,318,366
7,395,844
155,256
13,869,466
(Dollars in thousands) Six months ended June 30,
493,191
122,487
2,988
(2,653
44,800
(45,135
496,179
119,834
47,839
429,312
6,503
(34,452
4,009
(1,747
43,948
(46,210
433,321
4,756
9,496
369,321
143,822
1,241
5,260
(2,061
42,500
(45,699
374,581
141,761
43,741
320,557
17,488
(23,722
5,704
(1,850
41,846
(45,700
326,261
15,638
18,124
8
The following table summarizes unaffiliated gross premiums written and net premiums earned and other credit enhancement fees included in the financial guarantee segment by location of risk for the three and six month periods ended June 30, 2003 and 2002:
Three Months
Six Months
(Dollars in thousands)
Gross Premiums Written
Net Premiums Earned and Other Credit Enhancement Fees
United States
286,530
122,466
440,357
229,321
United Kingdom
66,590
7,354
78,644
14,277
Japan
6,683
13,168
12,301
Mexico
3,614
7,969
3,761
Australia
194
1,378
4,347
2,712
Germany
390
1,493
822
2,879
France
203
190
292
384
Internationally diversified (1)
9,519
15,417
16,012
29,275
Other international
12,389
7,551
21,613
14,492
Total
171,484
92,746
283,661
178,484
5,035
4,491
23,220
8,276
5,759
4,792
9,943
7,652
4,021
1,896
8,185
3,852
129
1,020
266
1,983
311
1,098
428
1,863
247
415
543
3,371
10,302
6,904
18,915
5,379
12,022
8,580
1) Internationally diversified includes guarantees with multiple locations of risk and includes components of United States exposure.
(3) Stock Options
Ambac sponsors the “1997 Equity Plan”, where awards are granted to eligible employees of Ambac in the form of non-qualified stock options or other stock-based awards. Prior to 2003, Ambac accounted for such awards under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”. No stock-based employee compensation cost is reflected in three and six months ended June 30, 2002 net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2003, Ambac adopted the fair value recognition provisions of FAS Statement No. 123, “Accounting for Stock-Based Compensation”, prospectively to all employee awards granted after January 1, 2003. Therefore, the cost related to stock-based employee compensation included in the determination of net income for the three and six months ended June 30, 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards prior to January 1, 2003. The following table illustrates the effect on net income and
9
earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period:
(Dollars in thousands, except per share information)
Three Months Ended June 30,
Six Months Ended June 30,
Net income, as reported
Add: Stock-based employee compensation included in reported net income, net of tax
850
1,621
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of tax
(3,601
(3,079
(7,124
(6,158
Pro-forma net income
159,820
116,682
294,991
230,555
Earnings per share:
As reported
Pro-forma
1.50
1.10
2.78
2.18
Earnings per diluted share:
1.46
1.07
2.71
2.11
(4) Accounting Standards
Financial Accounting Standards Board (“FASB”) Interpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN 46”) provides accounting and disclosure rules for variable interest entities (“VIE”). A VIE is an entity in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. VIEs are often created for a single specific purpose, for example, to facilitate asset securitization. FIN 46 became effective in the first quarter of 2003 for VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. It became effective July 1, 2003 for VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN 46 requires VIEs to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. FIN 46 requires disclosures for entities that have either a primary or significant variable interest in a VIE.
Ambac has involvement with VIEs in two ways. First, Ambac is a provider of financial guarantee insurance for various securitized asset-backed debt obligations, including mortgage backed security obligations, collateralized debt obligations (“CDO”) and other asset-backed securitization obligations. Second, Ambac has sponsored two VIEs that issue medium-term notes (“MTNs”) to fund the purchase of certain financial assets. As discussed in detail below, these special purpose entities are considered Qualifying Special Purpose Entities (“QSPEs”).
Ambac provides financial guarantee insurance to securitized asset-backed debt obligations of VIEs. The transaction structure provides certain financial protection to Ambac. This financial protection can take several forms, however, the most common are over-
10
collateralization, first loss retention and excess spread. In the case of over-collateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the securitized assets before a default is experienced on the structured finance obligations which have been guaranteed by Ambac. In the case of first loss retention, the financial guarantee insurance policy only covers a senior layer of losses on debt issued by the VIE. The expected losses on the assets are either retained by the seller or sold off in the form of equity and mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to a VIE generate cash flow in the form of interest that is in excess of the interest payments on the related debt. All or a portion of this excess spread accumulates and is available to absorb losses in the transaction. Ambac requires these financial protections as a condition for issuing its financial guarantee insurance policy.
It is possible however, that from time to time, Ambac will consolidate an entity for which it has issued a financial guarantee insurance policy. If Ambac issues a financial guarantee insurance policy for the obligations of a VIE and does not receive structural financial protection adequate to absorb the majority of expected loss, Ambac may be required to consolidate the related VIE in accordance with FIN 46. Ambac underwrites its insurance to a remote loss standard and normally demands structural financial protection that absorbs the majority of expected loss in a transaction. However, transactions may occur where the structural financial protections are outside of the VIE and as result this type of transaction could be consolidated under FIN 46. Upon the occurrence of certain events, the insurance policy may give Ambac certain rights to remediate potential or actual losses. These events include an asset manager or asset servicer breach of certain financial, corporate or performance covenants. A breach of these covenants may give Ambac the right to take certain actions such as replacing the asset manager or asset servicer. Depending upon the actions taken, Ambac may be required to consolidate the structure under FIN 46. As we underwrite to a remote loss standard, we expect such situations to be infrequent. However, management is committed to take actions to reduce economic loss regardless of any requirement to consolidate. Consolidation is an important accounting concept, however, it does not change the economic risk profile of the insurance exposure. Ambac’s insured exposures as of December 31, 2002, are disclosed in Note 12 “Guarantees in Force” of Ambac’s 2002 Annual Report.
Regarding QSPEs, Ambac has transferred financial assets to two VIEs. The business purpose of these entities is to provide certain financial guarantee clients with funding for their debt obligations. These entities meet the characteristics of QSPEs in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”). QSPEs are not subject to the requirements of FIN 46 and accordingly are not consolidated in Ambac’s financial statements. However, see the discussion below on the Exposure Draft recently issued by the FASB that could change the accounting rules for QSPEs in the future. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to those outlined below.
As of June 30, 2003, there have been 12 individual transactions processed through the QSPEs, of which 8 remain. In each case, Ambac sells fixed income debt obligations to the QSPEs. These transactions are true sales based upon the bankruptcy remote nature of the QSPE and the absence of any agreement or obligation for Ambac to repurchase or redeem assets of the QSPE. The purchase by the QSPE is financed through the issuance of MTNs, which are collateralized by the purchased assets. These MTNs approximately match the cash flow of the assets purchased. Derivative contracts may be used (interest rate and currency
11
swaps) for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase financial assets. The activities of the QSPEs are contractually limited to purchasing assets from Ambac, issuing MTNs to fund such purchase, executing derivative hedges and related administrative services. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs issued or both. As of June 30, 2003, Ambac Assurance had financial guarantee insurance policies issued for all assets and MTNs owned and outstanding by the QSPEs.
Ambac’s exposure under these financial guarantee insurance policies as of December 31, 2002, is included in the disclosure in Note 12 “Guarantees in Force” of Ambac’s 2002 Annual Report. Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPE and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides certain administrative duties, primarily collecting amounts due on the obligations and making interest payments on the MTNs.
Assets sold to the QSPEs during the six months ended June 30, 2003 and the year ended December 31, 2002 were $0 million and $350.0 million, respectively. No gains or losses were recognized on these sales. As of June 30, 2003, the estimated fair value of financial assets, MTN liabilities and derivative hedges were $1.4 billion, $ 1.3 billion and $100 million, respectively. When market quotes are not available, estimated fair value is determined utilizing valuation models. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market. Ambac Assurance received gross premiums and other fees for issuing financial guarantee policies on the assets and MTNs of $2.7 million and $19.3 million for the six months ended June 30, 2003 and for the year ended December 31, 2002, respectively. Ambac also received fees for providing administrative agency services amounting to $0.0 million and $0.1 million for the six months ended June 30, 2003 and the year ended December 31, 2002, respectively.
In June 2003, the FASB issued an Exposure Draft for proposed Statement of Financial Accounting Standards entitled “Qualifying Special-Purposes Entities and Isolation of Transferred Assets”, an amendment of FASB Statement No. 140 (“The Exposure Draft”). The Exposure Draft is a proposal that is subject to change and as such, is not yet authoritative. If the proposal is enacted in its current form, it will amend and clarify FAS 140. The Exposure Draft would prohibit an entity from being a QSPE if it enters into an agreement that obligates a transferor of financial assets, its affiliates, or its agents to deliver additional cash or other assets to fulfill the SPE’s obligations to beneficial interest holders. While Ambac is still evaluating the Exposure Draft, management believes that Ambac would consolidate its current QSPEs if this Statement becomes enacted as currently proposed and if the QSPEs issue new beneficial interests after the effective date and receive assets other than those they are committed to receive. It appears only static structures would be grand fathered under the proposal. This conclusion is based upon the fact that Ambac provides financial support to these entities such as financial guarantees and liquidity commitments. The impact of consolidation would be to gross up Ambac’s consolidated balance sheet for the assets and liabilities held by the QSPEs that approximate $1.4 billion at June 30, 2003. Additionally, fees received by Ambac from the QSPEs (primarily insurance premiums) would be eliminated in consolidation and essentially reclassified to net interest income. The risk characteristics of these transactions are not impacted by consolidation.
12
In April 2003, the FASB issued FAS Statement 149 “Amendment to Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”). This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FAS 133 “Accounting for Derivative Instruments and Hedging Activities”. The changes in FAS 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, FAS 149 (i) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative under FAS 133, (ii) clarifies when a derivative contains a financing component, (iii) amends the definition of an underlying obligation to conform it to language used in FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, and (iv) amends certain other pronouncements. Those changes will result in more consistent reporting of contracts as either derivatives or hybrid instruments. FAS 149 is effective for contracts entered into or modified after June 30, 2003, except in certain instances detailed in FAS 149, and hedging relationships designated after June 30, 2003. Except as otherwise stated in FAS 149, all provisions should be applied prospectively. FAS 149 will not have a material impact on Ambac.
In May 2003, the FASB issued FAS Statement 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“FAS 150”). FAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. FAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. FAS 150 will not have an impact on Ambac.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Ambac Financial Group, Inc., headquartered in New York City, is a holding company whose subsidiaries provide financial guarantee products and financial services to clients in both the public and private sectors around the world. Information about Ambac Financial Group is available through our web site at http://www.ambac.com. In addition, our press releases and filings with the Securities and Exchange Commission are available free of charge on the investor relations portion of our web site. Management has identified the accounting for loss and loss adjustment expenses and the valuation of financial instruments as critical accounting policies.
The reserve for losses and loss adjustment expenses consists of the active credit reserve and case basis credit loss and loss adjustment expense reserves. The active credit reserve is established based upon probable debt service defaults resulting from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on management’s review of each credit. When defaults occur, case basis credit loss reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under salvage or subrogation rights. These reserves are discounted in accordance with discount rates prescribed or permitted by state regulatory authorities. All or parts of case basis credit loss reserves are allocated from any active credit reserves available. Management believes that the reserves for losses and loss adjustment expenses are adequate to cover the ultimate net cost of claims, but the reserves are necessarily based on estimates and there can be no assurance that the ultimate liability will not exceed such estimates.
The following financial instruments are carried in the accompanying balance sheets at fair value: fixed income investment securities and derivatives used for hedging purposes and derivatives held for trading purposes. The fair values of fixed income investment securities are based primarily on quoted market prices received from a nationally recognized pricing service or dealer quotes. When quotes are not available, fair values are estimated based upon internal valuation models. The fair values of all derivatives are based on quoted dealer prices or pricing valuation models. All valuation models include estimates, made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.
Materials in this Form 10-Q may contain information that includes or is based upon forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements give Ambac’s expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts and relate to future operating or financial performance.
Any or all of Ambac’s forward-looking statements here or in other publications may turn out to be wrong and are based on current expectations and the current economic environment. Ambac’s actual results may vary materially, and there are no guarantees about the performance of our securities. Among factors that could cause actual results to differ materially are: (1) changes in the economic, credit or interest rate environment in the United States and abroad; (2) the level of activity within the national and worldwide debt markets; (3) competitive conditions and pricing levels; (4) legislative and regulatory developments; (5) changes in tax laws; (6) the policies and actions of the United States and other governments; and (7) other risks and uncertainties that have not been identified at this time. Ambac is not obligated to publicly correct or update any forward-looking statement if we later become aware that it is not likely to be achieved, except as required by law. You are advised, however, to consult any
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)
further disclosures we make on related subjects in Ambac’s reports to the Securities and Exchange Commission.
Results of Operations
The following paragraphs describe the consolidated results of operations of Ambac and its subsidiaries for the three and six-month periods ended June 30, 2003 and 2002, and its financial condition as of June 30, 2003 and December 31, 2002. These results are presented for Ambac’s two reportable segments: Financial Guarantee and Financial Services.
Consolidated Net Income
Ambac’s net income for the three months ended June 30, 2003 was $162.6 million or $1.48 per diluted share. This represents a 36% increase from the three months ended June 30, 2002 net income of $119.8 million or $1.09 per diluted share. Ambac’s income before income taxes was $219.9 million for the three months ended June 30, 2003, an increase of 38% from income before income taxes of $158.9 million in the three months ended June 30, 2002. Of the $219.9 million of income before income taxes in the second quarter of 2003, $237.0 million was from Financial Guarantee, ($2.4) million from Financial Services and $(14.7) million from Corporate, compared to $165.6 million, $5.7 million and $(12.4) million for Financial Guarantee, Financial Services and Corporate, respectively in the second quarter of 2002. Corporate consists primarily of Ambac’s interest expense and other expenses, partially offset by investment income. Financial Guarantee income before income taxes increased as a result of (i) higher net premiums earned and other credit enhancement fees, (ii) higher net realized investment gains (iii) mark-to-market gains on credit derivative contracts and (iv) higher net investment income, partially offset by (i) a higher provision for losses and loss adjustment expenses, and (ii) higher operating expenses. The Financial Services decline is primarily attributable to lower swap revenues
Ambac’s net income for the six months ended June 30, 2003 was $300.5 million or $2.75 per diluted share. This represents an increase of 27% from the comparable prior period net income of $236.7 million or $2.17 per diluted share in the six months ended June 30, 2002.
Ambac provides financial guarantees for debt obligations through its principal operating subsidiary, Ambac Assurance, as well as credit protection in the form of structured credit derivatives through Ambac Credit Products LLC, a wholly owned subsidiary of Ambac Assurance. Ambac provides these services in three principal markets: public finance, structured finance and international finance.
Public finance obligations are bonds issued by states, municipalities and other governmental or not-for-profit entities located in the United States (“Public Finance”). Bond proceeds are used to finance or refinance a broad spectrum of public purpose initiatives, including education, utility, transportation, health care and other general purpose projects. Although Ambac guarantees the full range of Public Finance obligations, Ambac continues to seek transaction flow on those deals that require more structuring skills. Certain projects, which had been financed by the local or U.S. government alone are now being financed through public-private partnerships. In these transactions, debt service on the bonds, rather than being paid solely by tax revenues or other governmental funds, are being paid from a variety of
revenue sources, including revenues derived from the project itself. Examples of these deals include stadium financings, student housing and military housing.
Structured finance obligations include the securitization of a variety of asset types such as mortgages, home equity loans, leases and domestic pooled debt obligations (“Structured Finance”). Currently, the largest component of Ambac’s Structured Finance business relates to the securitization of mortgages and home equity loans. Another target area in Structured Finance is the credit enhancement of pooled debt obligations including structured credit derivatives. These transactions involve the securitization of a portfolio of corporate bonds and loan obligations and asset-backed securities (the “Securitized Assets”). Ambac’s exposure to these Securitized Assets is mitigated through first loss protection. Typically, first loss protection is in the form of over-collateralization (i.e., the principal amount of the Securitized Assets exceeds the principal amount of the structured finance obligations guaranteed by Ambac Assurance), which allows the transaction to experience defaults among the Securitized Assets before a default is experienced on the structured finance obligations which have been guaranteed by Ambac.
International finance obligations include public purpose infrastructure projects and asset-backed securities (“International Finance”). Ambac’s emphasis internationally has been on Western Europe, Japan and Australia. In the United Kingdom, ongoing privatization efforts have shifted certain risks associated with the development or operation of infrastructure projects from the government to market participants, thus prompting investors in such projects to seek the security of financial guarantee products. Ambac Assurance is party to an alliance in Japan with Sompo Japan Financial Guarantee Insurance Co., Ltd, a monoline financial guarantor in Japan. Ambac also participates in developing markets through certain structures such as pooled debt obligations or future flow transactions. Future flow transactions essentially securitize future revenue streams derived from operating receivables or the sale of commodities.
Gross Par Written. Ambac Assurance guaranteed $33.8 billion in par value bonds during the three months ended June 30, 2003, an increase of 49% from $22.7 billion in par value bonds guaranteed during the comparable prior year period. Par value written for the second quarter of 2003 was comprised of $13.3 billion from Public Finance bond obligations, $16.5 billion from Structured Finance obligations and $4.0 billion from International Finance obligations, compared to $12.0 billion, $8.4 billion and $2.3 billion, respectively, in the second quarter of 2002.
During the six months ended June 30, 2003, Ambac Assurance guaranteed $63.4 billion in par value bonds, a 61% increase from $39.5 billion in par during the first six months of 2002. Par value written for the six months ended June 30, 2003 was comprised of $21.9 billion from Public Finance bond obligations, $29.3 billion from Structured Finance obligations and $12.2 billion from International Finance obligations, compared to $18.8 billion, $15.7 billion and $5.0 billion, respectively, in the six months ended June 30, 2002.
The increase in guaranteed Public Finance obligations for the three and six months ended June 30, 2003 was affected by a 20% and 23%, respectively, increase in total public finance issuance. Insured market penetration remained relatively flat at 52% and 53% for the three and six months ended June 30, 2003 and 2002, while Ambac’s market share declined in the second quarter and six months of 2003 to 19% from 23% and 21% in the second quarter and six months of 2002, respectively. The increase in total issuance was largely the result of the lower interest rate environment, causing an increase in both the refinancing and new money
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components of the market. Also contributing to the increased issuance is the budget deficits of municipalities throughout the United States. The increase in Structured Finance obligations guaranteed resulted from strong business activity in the consumer and commercial asset-backed sectors of the market. International Finance obligations guaranteed during the period increased primarily due to significant activity in the transportation area as well as a higher number of pooled debt obligations written.
Gross Premiums Written. Ambac receives insurance premiums either up front at policy issuance or on an installment basis over the life of the transaction. The collection method is determined at the time of policy issuance. Gross premiums written for the three and six months ended June 30, 2003 were $386.0 million and $583.2 million, respectively, an increase of $190.3 million or 97% from $195.7 million in the three months ended June 30, 2002 and an increase of $238.2 million or 69% from $345.0 million in the six months ended June 30, 2002. Up-front premiums written during the three and six months ended June 30, 2003 were $283.5 million and $385.1 million, respectively, an increase of 151% from $113.0 million in the three months ended June 30, 2002 and an increase of 108% from $184.8 million in the six months ended June 30, 2002. These increases for the three and six months ended June 30, 2003 are a result of increased business activity across all three markets, Public Finance, Structured Finance and International Finance.
Installment premiums written for the three and six months ended June 30, 2003 were $102.5 million and $198.1 million, respectively, an increase of 24% from $82.7 million and $160.2 million in the three and six months ended June 30, 2002. The growth in installment premiums is due to the increased business activity in both Structured and International Finance, partially offset by a decrease in installment Public Finance premiums written.
The following tables set forth the amounts of gross premiums written and the related gross par written by type:
(Dollars in Millions)
Gross Par Written
Public Finance:
Up-front
205.2
12,529
98.2
10,153
Installment
6.1
736
10.6
1,804
Total Public Finance
211.3
13,265
108.8
11,957
Structured Finance:
17.2
849
14.4
1,552
58.1
15,668
48.3
6,876
Total Structured Finance
75.3
16,517
62.7
8,428
International Finance:
61.1
1,196
0.4
249
38.3
2,773
23.8
2,102
Total International Finance
99.4
3,969
24.2
2,351
386.0
33,751
195.7
22,736
Total up-front
283.5
14,574
113.0
11,954
Total installment
102.5
19,177
82.7
10,782
17
282.9
20,323
150.3
16,045
12.3
1,602
20.5
2,725
295.2
21,925
170.8
18,770
32.7
1,879
20.4
1,938
112.5
27,465
92.4
13,796
145.2
29,344
112.8
15,734
69.5
1,828
14.1
622
73.3
10,329
47.3
4,410
142.8
12,157
61.4
5,032
583.2
63,426
345.0
39,536
385.1
24,030
184.8
18,605
198.1
39,396
160.2
20,931
Ceded Premiums Written. Ceded premiums written for the three and six months ended June 30, 2003 were $42.3 million and $73.5 million, respectively, an increase of 71% from $24.7 million in the three months ended June 30, 2002 and an increase of 66% from $44.3 million in the six months ended June 30, 2002. Ambac’s reinsurance program is comprised of a surplus share treaty reinsurance program and facultative reinsurance. The surplus share treaty requires Ambac to cede covered transactions while retaining flexibility to cede those transactions within a pre-defined range. Certain types of transactions are excluded from the surplus share treaty and management may use facultative reinsurance to cede such risks. Ceded premiums written as a percentage of gross premiums written were 11.0% and 12.6% for the three and six months ended June 30, 2003, respectively, compared with 12.6% and 12.8% for the three and six months ended June 30, 2002, respectively. The size of insured transactions can be large and management’s determination of risk retention on such deals impacts the total cede percentage. Accordingly, the reduction in ceded premiums written as a percentage of gross premiums written in the second quarter is primarily due to management’s decision to retain a greater participation in certain large transactions in the three months ended June 30, 2003.
The reinsurance of risk does not relieve Ambac of its original liability to its policyholders. In the event that any of Ambac’s reinsurers are unable to meet their obligations under reinsurance contracts, Ambac would be liable for such defaulted amounts. To minimize exposure to significant losses from reinsurers, Ambac (i) evaluates the financial condition of its reinsurers; (ii) has collateral provisions in certain reinsurance contracts; and (iii) has certain termination triggers that can be exercised by Ambac in the event of a rating downgrade of a reinsurer. Ambac held letters of credit and collateral amounting to approximately $135.7 million from its reinsurers. The following table provides ceded par outstanding by financial strength rating of Ambac’s reinsurers, on a Standard and Poor’s (“S&P) basis:
(Dollars in billions)
AAA
17.4
AA
15.2
A
8.1
Not rated
7.6
44.2
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On January 13, 2003, S&P lowered the financial strength rating of AXA Re Finance S.A. from AAA to BBB. The ratings were withdrawn at AXA Re Finance S.A. management’s request. This downgrade was attributable to AXA Re Finance S.A.’s decision to cease writing new financial guarantee business. On March 27, 2003, S&P lowered the financial strength rating of American Re-Insurance Company from AA- to A+. The downgrade was because of the recent downgrade of American Re-Insurance Co.’s ultimate parent. The downgrades give Ambac the contractual right to terminate all reinsurance agreements with both AXA Re Finance S.A. and American Re-Insurance Company. Ambac is currently exploring whether or not to exercise this contractual right. When a reinsurer is downgraded, less capital credit is given to Ambac under rating agency models. The reduced capital credit has not and is not expected to have a material adverse effect on Ambac.
Net Premiums Earned and Other Credit Enhancement Fees. Net premiums earned and other credit enhancement fees during the three and six months ended June 30, 2003 were $164.3 million and $309.4 million, respectively, an increase of 37% from $120.2 million for the three months ended June 30, 2002 and an increase of 34% from $230.1 million for the six months ended June 30, 2002. These increases were primarily the result of the larger Financial Guarantee book of business, higher refundings, calls and other accelerations of previously insured obligations (collectively referred to as “refundings”) and higher other credit enhancement fees earned from the structured credit derivatives business.
When an issue insured by Ambac Assurance has been refunded or called, any remaining unearned premium (net of refunding credits, if any) is earned at that time. Refunding levels vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Net premiums earned during the three and six months ended June 30, 2003 included $21.1 million and $33.2 million from refundings of previously insured issues. Net premiums earned during the three and six months ended June 30, 2002 included $11.2 million and $18.5 million from refundings of previously insured issues.
Excluding the effect of accelerated earnings related to refundings, normal net premiums earned (which is defined as net premiums earned less refundings) increased 28% from $102.4 million in the second quarter of 2002 to $130.9 million in the second quarter of 2003. Normal net premiums earned for the six months ended June 30, 2003 were $253.5 million, an increase of 28% from $198.7 million in the six months ended June 30, 2002. The increases in normal net premiums earned resulted primarily from the continued growth in the insured book of business in all markets. Normal net premiums earned during the three months ended June 30, 2003 increased 16%, 31% and 42% for Public, Structured and International Finance, respectively, from the three months ended June 30, 2002. Normal net premiums earned during the six months ended June 30, 2003 increased 16%, 28% and 49% for Public, Structured and International Finance, respectively, from the six months ended June 30, 2002.
Other credit enhancement fees, which is primarily comprised of fees received from the structured credit derivatives product, during the three and six months ended June 30, 2003 were $12.3 million and $22.7 million, respectively, an increase of 86% from $6.6 million in the three months ended June 30, 2002 and an increase of 76% from $12.9 million in the six months ended June 30, 2002. The increases are due to the continued growth in the structured credit derivatives business.
The following table provides a breakdown of net premiums earned by market sector and other credit enhancement fees:
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Public Finance
44.4
38.2
87.4
75.2
Structured Finance
55.6
42.5
106.0
83.1
International Finance
30.9
21.7
60.1
40.4
Total normal premiums earned
130.9
102.4
253.5
198.7
Refundings
21.1
11.2
33.2
18.5
Total net premiums earned
152.0
113.6
286.7
217.2
6.6
22.7
12.9
Total net premiums earned and other credit enhancement fees
164.3
120.2
309.4
230.1
Net Investment Income. Net investment income for the three and six months ended June 30, 2003 was $79.9 million and $156.5 million, an increase of 9% from $73.6 million in the three months ended June 30, 2002 and an increase of 7% from $146.1 million in the six months ended June 30, 2002. These increases were primarily attributable to (i) the growth of the investment portfolio resulting from the growth in the Financial Guarantee book of business and (ii) a capital contribution from Ambac Financial Group, Inc. totaling approximately $75 million during the first quarter of 2003. The capital contribution is a result of Ambac Financial Group’s issuance of $200.0 million of debentures in February 2003. Net investment income in 2003 was negatively impacted by the low interest rate environment. Investments in tax-exempt securities amounted to 72% of the total fair value of the portfolio as of June 30, 2003, versus 68% at June 30, 2002.
The average pre-tax yield-to-maturity on the investment portfolio was 5.04% and 5.66% as of June 30, 2003 and 2002, respectively.
Net Realized Investment Gains. Net realized investment gains in the three and six months ended June 30, 2003 were $12.8 million and $26.7 million, respectively, compared to net realized gains of $3.5 million and $3.0 million for the three and six months ended June 30, 2002. The following table details amounts included in net realized investment gains:
Net gains on securities sold
5.8
0.5
19.8
0.9
Foreign exchange gains on investments
7.0
3.0
6.9
2.1
Net securities gains
12.8
3.5
26.7
Net Mark-to-Market Gains (Losses) on Credit Derivative Contracts. Net mark-to-market gains (losses) on credit derivative contracts for the three and six months ended June 30, 2003 were $10.0 million and ($2.2) million, respectively, compared to net mark-to-market losses of ($8.0) million and ($12.1) million in the three and six months ended June 30, 2002. Change in net mark-to-market gains and losses on structured credit derivatives are impacted by a number of factors. The primary factors impacting the net mark-to-market are credit spreads in the underlying obligations of the structure, credit events which erode subordination of the structure and observable pricing for the tranche that Ambac guarantees (replacement cost). The net mark-to-market gain in the second quarter of 2003 resulted primarily from the narrowing of corporate credit spreads during the period. Paid losses on structured credit derivatives in the three and six months ended June 30, 2003 totaled $1.2 million compared to $1.5 million for the three and six months ended June 30, 2002.
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Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for the three and six months ended June 30, 2003 were $10.9 million and $20.7 million, respectively, compared to $5.9 million and $11.6 million for the three and six months ended June 30, 2002, respectively. Losses and loss adjustment expenses are based upon estimates of the ultimate aggregate losses inherent in the Financial Guarantee portfolio. In most instances, claim payments are forecasted in advance as a result of Ambac’s active surveillance of the insured book of business. Based upon company and industry experience, claim payments become probable and estimable once the issuer’s credit profile has migrated to certain impaired credit levels. The insured party has the right to a claim under Ambac’s financial insurance policy at the first scheduled debt service date of the defaulted obligation. The trustee for the insured obligation notifies Ambac of the payment default so that a claim payment can be made. The trustee reports payment defaults at or prior to the scheduled payment date. Subsequent claims would be paid if payment defaults continue and would be based on the originally scheduled interest and principal payment schedule.
The liability for losses and loss adjustment expenses consists of case basis credit and active credit reserves. Case basis credit reserves are established for losses on guaranteed obligations that have already defaulted. These reserves are established in an amount that is sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under collateral and subrogation rights. As noted above, the payment pattern and ultimate costs are fixed and determinable on an individual claim basis (i.e., the originally scheduled debt service of the insured obligation). Ambac discounts these reserves in accordance with discount rates prescribed or permitted by state regulatory authorities. Consistent with industry practice, we also establish and accrue an active credit reserve, which is separate from the case basis credit reserves noted above. We believe, based on our active surveillance of the insured portfolio, along with historical defaults and related loss data and current economic factors, that additional losses are inherent in our portfolio. Current economic factors considered include estimates of current defaults and recovery values from collateral or subrogation rights. The active credit reserve is established based upon probable debt service defaults from incurred losses, as a result of credit deterioration. Reserve amounts are reasonably estimated based on management’s review of each credit. Active surveillance of the insured portfolio enables Ambac to track credit migration of insured obligations from period to period. Our Surveillance group, which is comprised of senior credit professionals, all of whom are independent from transaction execution, is responsible for extensive ongoing review of every credit to which Ambac has exposure. At least monthly, Senior Finance and Credit Management meets with Surveillance to review the status of their work. During the monthly review, Senior Management determines the adequacy of Ambac’s loss reserves and makes any necessary adjustments. The following table summarizes Ambac’s loss reserves split between case basis credit loss reserves and active credit reserves at June 30, 2003 and December 31, 2002.
(Dollars in millions)
Net loss and loss adjustment expense reserves:
Case basis reserves *
57.9
49.0
Active credit reserves
120.0
118.6
177.9
167.6
(*)
After netting reinsurance recoverable amounting to $3.9 million and $4.6 million at June 30, 2003 and December 31, 2002, respectively.
The following table summarizes the changes in the total net loss reserves for the six months ended June 30, 2003 and the year-ended December 31, 2002:
Beginning balance of net loss reserves
150.1
Additions to loss reserves
20.7
Losses paid
(11.7
(11.1
Recoveries of paid losses from reinsurers
1.3
Recoveries of previously paid losses
0.6
Ending balance of net loss reserves
At June 30, 2003 case basis credit reserves are sufficient to cover management’s estimate of gross losses through 2026 totaling $76.6 million for credits currently in default. Annual debt service payments on credits with case basis credit reserves are estimated at $14.9 million, $15.4 million, $14.8 million, $9.0 million and $5.6 million for the remainder of 2003, 2004, 2005, 2006 and 2007, respectively. For Public Finance transactions, debt service is equal to the known scheduled principal and interest due on the insured obligations. For Structured Finance transactions that do not have defined payment schedules, debt service is estimated based on management’s judgment, about the timing and extent of deterioration in the underlying collateral pool.As these debt service amounts are estimates, there can be no assurance that the ultimate payments will not exceed such estimates.
Additions made to the case basis credit reserve for the six months ended June 30, 2003 were $8.9 million. These additions to the case basis loss reserves during the six months ended June 30, 2003 primarily related to three mortgage-backed securitizations. These three mortgage-backed securitizations have experienced credit deterioration and Ambac has paid net claims of approximately $8.4 million on these three securitizations during the six months ended June 30, 2003. Remaining net par exposure on these three securitizations is approximately $738 million at June 30, 2003. The net claims paid and case basis credit reserve for the three mortgage securitizations are included in the Structured Finance market sector. The following tables provide details of net losses paid for the six months ended June 30, 2003 and 2002 and case basis credit reserves at June 30, 2003 and December 31, 2002 by market sector:
June 30, 2002
Net losses paid:
1.8
2.3
8.4
0.1
0.2
10.4
2.4
Net case basis credit reserves:
22.0
19.0
32.0
26.1
3.9
Underwriting and Operating Expenses. Underwriting and operating expenses for the three and six months ended June 30, 2003 were $21.0 million and $43.2 million, respectively, an increase of 13% from $18.6 million in the three months ended June 30, 2002 and an increase of 16% from $37.2 million in the six months ended June 30, 2002. Underwriting and operating expenses consist of gross underwriting and operating expenses, less the deferral to
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future periods of expenses and reinsurance commissions related to the acquisition of new insurance contracts, plus the amortization of previously deferred expenses and reinsurance commissions. The increase reflects the overall increased business activity and is primarily attributable to higher compensation costs related to the addition of staff and the expensing of stock options, which began in 2003, partially offset by higher profit commission collected on the reinsured book of business. Underwriting and operating expenses deferred for the three and six months ended June 30, 2003 were $21.8 million and $40.3 million, respectively, compared to $17.5 million and $33.9 million for the three and six months ended June 30, 2002. The amortization of previously deferred expenses and reinsurance commissions for the three and six months ended June 30, 2003 were $9.6 million and $18.6 million, respectively, compared to $7.9 million and $15.8 million for the three and six months ended June 30, 2002, respectively.
Through its Financial Services subsidiaries, Ambac provides financial and investment products including investment agreements, interest rate swaps, total return swaps, funding conduits, investment advisory and cash management services, to municipalities and their authorities, school districts, health care organizations and asset-backed issuers.
Net Revenues. Financial Services net revenue is defined by management as gross interest income less gross interest expense from investment and payment agreements plus other revenue and realized and unrealized gains and losses. Net Financial Services revenues for the three and six months ended June 30, 2003 were $3.8 million and $18.9 million, respectively, a decrease of 67% from $11.4 million in the three months ended June 30, 2003 and down 33% from $28.3 million in revenues for the six months ended June 30, 2003. The three primary activities within financial services are operations from our guaranteed investment contract, interest rate swap and cash management services.
Net interest income from our guaranteed investment contract product declined $1.1 million and $1.2 million in the three and six months ended June 30, 2003, respectively, from the three and six months ended June 30, 2002. This product was adversely impacted by the continued decline in interest rates. The decline in interest rates results in lower income on cash held for liquidity purposes. Additionally, certain mortgage-backed investments tend to prepay causing the related proceeds to be reinvested at lower yields. Revenue from our interest rate swap product in the second quarter of 2003 declined $10.9 million and $12.4 million in the three and six months ended June 30, 2003, respectively, from the three and six months ended June 30, 2002. This product was adversely impacted in the second quarter of 2003 by a $12 million mark-to-market adjustment due to an increase in the ratio of tax-exempt interest rates to taxable interest rates. Currently, this ratio is higher than historical averages and has been impacted by the historically low interest rate environment and large supply of municipal debt. Revenue from our cash management product in the second quarter of 2003 was relatively flat as compared to the second quarter of 2002. Revenue from the cash management product in the six months ended June 30, 2003 declined $0.7 million from the six months ended June 30, 2002.
Net realized investment gains were $4.6 million and $4.9 million for the three and six months ended June 30, 2003, respectively, compared to $0.4 million and $0.6 million for the three and six months ended June 30, 2002, respectively. Gains and losses from investment securities are due to the normal operations of the guaranteed investment contract business, and shaping of the investment portfolio to maximize yield within our defined risk guidelines. Ambac does not maintain a trading portfolio.
23
Other Expenses. Other expenses for the three and six months ended June 30, 2003 were $6.2 million and $12.4 million, respectively, up 9% from $5.7 million in the three months ended June 30, 2002 and up 15% from $10.8 million in the six months ended June 30, 2002. The increase during the second quarter of 2003 was primarily due to higher compensation expenses, including the addition of stock option expense. The increase for the six months ended June 30, 2003 was primarily due to a reversal of employee benefit accruals in the first quarter of 2002 and the addition of stock option expense in the first quarter of 2003.
Corporate Items
Interest Expense. Interest expense for the three and six months ended June 30, 2003 was $14.5 million and $27.0 million, respectively, an increase of 34% from $10.8 million in the three months ended June 30, 2002 and an increase of 26% from $21.5 million in the six months ended June 30, 2002. The increase is primarily attributable to Ambac’s issuance of $200 million, 5.95% debt, due February 28, 2103, issued in February 2003 and the issuance of $175 million, 5.875%, due March 24, 2103, issued in March 2003. This was partially offset by the redemption at par of Ambac’s $200 million, 7.08% Debentures in April 2003. For additional information, please refer to “Liquidity and Capital Resources – Ambac Financial Group, Inc. Liquidity” section.
Corporate Expense. Corporate expenses include the operating expenses of Ambac Financial Group. Corporate expenses for the three and six months ended June 30, 2003 were $2.2 million and $10.5 million, respectively, compared to $2.0 million and $3.5 million for the three and six months ended June 30, 2002, respectively. The increase in the six months ended June 30, 2003 is primarily attributable to a $6.5 million write-off of previously deferred issuance expenses related to the 1998 issuance of $200 million, 7.08% Debentures, that was redeemed at par at the end of April 2003.
Income Taxes. Income taxes for the three and six months ended June 30, 2003 were at an effective rate of 26.1% and 25.1%, respectively, compared to 24.7% for the three and six months ended June 30, 2002. The increase in the effective rate is primarily the result of the higher taxable profits stemming from the financial guarantee segment.
Supplemental Analytical Financial Data
Management, equity analysts and investors consider adjusted gross premiums written important in analyzing the financial results of Ambac because it is considered an indication of premium production during the period. However, adjusted gross premiums written is not promulgated in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and should not be considered a substitute for gross premiums written. The definition of adjusted gross premiums written described below may differ from the definition used by other public holding companies of financial guarantee insurers.
Adjusted Gross Premiums Written. Ambac defines adjusted gross premiums written as gross (direct and assumed) up-front premiums written plus the present value of estimated installment premiums written on insurance policies and structured credit derivatives issued in the period. Adjusted gross premiums for the three and six months ended June 30, 2003 were $455.2 million and $777.6 million, respectively, an increase of 65% from $276.7 million in the three months ended June 30, 2002 and an increase of 59% from $488.6 million in the six
24
months ended June 30, 2002. For the first six months of 2003, adjusted gross premium growth was achieved in all markets.
The following table reconciles adjusted gross premiums written to gross premiums written for the three and six months ended June 30, 2003 and 2002:
Adjusted gross premiums written
455.2
276.7
777.6
488.6
Present value of estimated installment premiums written on insurance policies and structured credit derivatives issued in the period
(171.7
(163.7
(392.5
(303.8
Gross up-front premiums written
Gross installment premiums written on insurance policies
Public Finance adjusted gross premiums for the three and six months ended June 30, 2003 were $223.3 million and $311.6 million, respectively, an increase of 65% from $135.4 million in the three months ended June 30, 2002 and an increase of 49% from $209.0 million in the six months ended June 30, 2002. The increase is primarily the result of the continued high level of municipal issuance. Transactions guaranteed during the six months of 2003 included strong writings in the health care, municipal lease and transportation sectors of the market.
Structured Finance adjusted gross premiums for the three and six months ended June 30, 2003 were $144.0 million and $251.4 million, respectively, an increase of 41% from $101.8 million in the three months ended June 30, 2002 and an increase of 39% from $180.9 million in the six months ended June 30, 2002. Increases in this market were driven by strong activity in both the consumer and commercial asset-backed sectors.
International Finance adjusted gross premiums for the three and six months ended June 30, 2003 were $87.9 million and $214.6 million, respectively, an increase of 123% from $39.5 million in the three months ended June 30, 2002 and an increase of 117% from $98.7 million in the six months ended June 30, 2002. International Finance experienced strong activity across several sectors, and closed a large transportation transaction during the second quarter of 2003, as well as three large transportation transactions in the first quarter of 2003.
The following table sets forth the amounts of adjusted gross premiums by type and percent of total for the three and six months ended June 30, 2003 and 2002:
25
%
Public Finance policies:
Up-front policies:
45
36
31
18.1
37.2
28.7
58.7
Total Public Finance policies
223.3
49
135.4
311.6
40
209.0
43
Structured Finance policies:
126.8
28
32
218.7
160.5
Total Structured Finance policies
144.0
101.8
251.4
180.9
International policies (1):
26.8
39.1
145.1
84.6
Total International policies
87.9
39.5
214.6
98.7
Total adjusted gross premiums
100
62
41
50
171.7
163.7
59
392.5
303.8
(1)
Adjusted gross premiums written include reinsurance assumed of $0.0 million and $0.0 million in the second quarter and six months ended June 30, 2003, respectively and $0.0 million and $0.9 million in the second quarter and six months ended June 30, 2002, respectively.
Liquidity and Capital Resources
Ambac Financial Group, Inc. Liquidity. Ambac’s liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon (i) Ambac Assurance’s ability to pay dividends or make other payments to Ambac; (ii) external financings; and (iii) investment income from its investment portfolio. Pursuant to Wisconsin insurance laws, Ambac Assurance may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. During the six months ended June 30, 2003, Ambac Assurance paid dividends of $44.8 million on its common stock to Ambac.
Ambac’s principal uses of liquidity are for the payment of its operating expenses, income taxes, interest on its debt, dividends on its shares of common stock, purchases of its common stock in the open market and capital investments in its subsidiaries. Ambac contributed $75 million to Ambac Assurance during the first quarter of 2003. Based on the amount of dividends that it expects to receive from Ambac Assurance and other subsidiaries during the next twelve months and the income it expects to receive from its investment portfolio, management believes that Ambac will have sufficient liquidity to satisfy its needs over the next twelve months, including the ability to pay dividends on its common stock in accordance with its dividend policy. Beyond the next twelve months, Ambac Assurance’s ability to declare and pay dividends to Ambac may be influenced by a variety of factors, including adverse market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although management believes that Ambac will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, no guarantee can be given that Ambac Assurance will be permitted to dividend amounts sufficient to pay all of Ambac’s operating expenses, debt service obligations and dividends on its common stock.
Ambac Assurance Liquidity. The principal uses of Ambac Assurance’s liquidity are the payment of operating expenses, claims, reinsurance premiums, taxes, dividends to Ambac and
26
capital investments in its subsidiaries. Management believes that Ambac Assurance’s operating liquidity needs can be funded exclusively from its operating cash flow. The principal sources of Ambac Assurance’s liquidity are gross premiums written, scheduled investment maturities, net investment income and receipts from structured credit derivatives.
Financial Services Liquidity. The principal uses of liquidity by financial services subsidiaries are payment of investment agreement obligations pursuant to defined terms, net obligations under interest rate swaps and related hedges, operating expenses, income taxes and dividends to Ambac. Management believes that its Financial Services liquidity needs can be funded primarily from its operating cash flow and the maturity of its invested assets. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities of securities from its investment portfolio (which are invested with the objective of matching the maturity schedule of its obligations under the investment agreements), net receipts from interest rate swaps and related hedges, and fees for investment management services. Additionally, from time to time, liquidity needs of the financial services subsidiaries are satisfied by short-term inter-company loans from Ambac Assurance or Ambac Financial Group. The investment objectives with respect to investment agreements are to achieve the highest after-tax total return, subject to a minimum average credit quality rating of Aa/AA on invested assets, and to maintain cash flow matching of invested assets to funded liabilities to minimize interest rate and liquidity exposure. Financial Services subsidiaries maintain a portion of their assets in short-term investments and repurchase agreements in order to meet unexpected liquidity needs.
Credit Facilities. Ambac and Ambac Assurance have a revolving credit facility with eight major international banks for $300 million, which expires in July 2004 and provides a two-year term loan provision. The facility is available for general corporate purposes, including the payment of claims. As of June 30, 2003 and December 31, 2002, no amounts were outstanding under this credit facility. This facility’s financial covenants require that Ambac: (i) maintain as of the end of each fiscal quarter a debt to capital ratio of not more than 30% and (ii) maintain at all times total stockholders’ equity equal to or greater than $2.00 billion.
Capital Support. Ambac Assurance has a series of perpetual put options on its own preferred stock. The counterparty to these put options are trusts established by a major investment bank. The trusts were created as a vehicle for providing capital support to Ambac Assurance by allowing Ambac Assurance to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put option were exercised, the preferred stock holdings of Ambac Assurance would give investors the rights of an equity investor in Ambac Assurance. Such rights are subordinate to insurance claims, as well as to the general unsecured creditors of Ambac Assurance. If exercised, Ambac Assurance would receive up to $800 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose including the payment of claims. Dividend payments on the preferred stock are cumulative only if Ambac Assurance pays dividends on its common stock. Each trust is restricted to holding high quality short-term commercial paper investments to ensure that it can meet its obligations under the put option. To fund these investments, each trust has issued its own auction market perpetual preferred stock. Each trust is rated AA/Aa2 by Standard & Poor’s and Moody’s respectively.
From time to time Ambac accesses the capital markets to support the growth of its businesses. In April 2003, Ambac filed Form S-3 with the SEC utilizing a “shelf” registration process. Under this process, Ambac may issue up to $500 million of the securities described in
27
the prospectus filed as part of the registration, namely, common stock, preferred stock and debt securities of Ambac.
Stock Repurchase Program. The Board of Directors of Ambac has authorized the establishment of a stock repurchase program that permits the repurchase of up to 12,000,000 shares of Ambac’s Common Stock. During the six months ended June 30, 2003, Ambac acquired approximately 396,000 shares for an aggregate amount of $23.8million. Since inception of the Stock Repurchase Program, Ambac has acquired approximately 9,363,000 shares for an aggregate amount of $289.8 million.
Balance Sheet. Total assets as of June 30, 2003 were $16.80 billion, an increase of 9% from total assets of $15.36 billion at December 31, 2002. This increase was due primarily to cash generated from business written during the period, proceeds from debt issuance and increased volume in the guaranteed investment agreement business. As of June 30, 2003, stockholders’ equity was $4.04 billion, an 11% increase from year-end 2002 stockholders’ equity of $3.63 billion. The increase stemmed primarily from net income during the period and an increase in the fair market value of the investment portfolio resulting from the decline in interest rates during the period.
Ambac has a formal review process for all securities in its investment portfolio, including a review for impairment losses. Factors considered when assessing impairment include: (i) securities whose fair values have declined by 20% or more below amortized cost for a continuous period of at least six months; (ii) recent credit downgrades by rating agencies; (iii) the financial condition of the issuer; (iv) whether scheduled interest payments are past due; and (v) whether Ambac has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in Accumulated Other Comprehensive Income in stockholders’ equity on our Consolidated Balance Sheets. If we believe the decline is “other than temporary”, we reduce the carrying value of the investment and record a loss on our Consolidated Statements of Operations. Ambac’s assessment of a decline in value includes management’s current judgment of the factors noted above. If that judgment changes in the future, Ambac may ultimately record a loss after having originally concluded that the decline in value was temporary. The following table summarizes, for all securities in an unrealized loss position as of June 30, 2003 and December 31, 2002, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position:
Estimated Fair Value
Gross Unrealized Losses
Municipal obligations in continuous unrealized loss for:
0 – 6 months
236.0
3.1
146.1
7 – 12 months
0.3
Greater than 12 months
26.9
1.9
242.9
3.6
173.9
4.6
Corporate obligations in continuous unrealized loss for:
32.5
461.1
7.5
50.9
0.7
2.2
57.7
8.0
106.7
141.1
9.1
586.3
27.8
Foreign government obligations in continuous unrealized loss for:
1.6
U.S. government obligations in continuous unrealized loss for:
15.9
Mortgage and asset-backed securities in continuous unrealized loss for:
1,691.0
10.2
576.8
3.2
245.0
2.9
11.7
37.7
33.1
1.0
1,973.7
13.7
621.6
4.3
2,357.7
26.4
1,399.3
37.0
There were no impairment write-downs during the six months ended June 30, 2003 and 2002. The net realized investment gains in the three and six months ended June 30, 2003 and 2002 were the result of security sales made in the usual course of business in order to achieve Ambac’s investment objectives for the Financial Guarantee and Financial Services investment portfolios.
The amortized cost and estimated fair value of investments in fixed income securities and short-term investments at June 30, 2003 were as follows:
29
Amortized Cost
Fixed income securities:
Municipal obligations
5,117,031
5,530,034
Corporate obligations
1,334,915
1,454,278
Foreign government obligations
122,288
136,512
U.S. government obligations
88,661
93,836
Mortgage and asset-backed securities (includes U.S. government agency obligations)
5,569,972
5,670,741
Short-term
12,622,012
13,274,546
Fixed income securities pledged as collateral:
519,199
13,141,211
13,793,152
The following table provides the ratings distribution of the Financial Guarantee investment portfolio at June 30, 2003 and December 31, 2002:
Rating (1)
AAA(2)
73
BBB
1
Below investment grade
<1
Not Rated
Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s rating is used.
(2)
Includes U.S. Treasury and agency obligations, which comprised approximately 15% of the Financial Guarantee investment portfolio as of June 30, 2003 and December 31, 2002.
Approximately 96% and 98% of the mortgage and asset-backed securities in the Financial Guarantee portfolio is composed of securities issued by various U.S. government agencies, as of June 30, 2003 and December 31, 2002, respectively.
Short-term investments in the Financial Guarantee portfolio consisted primarily of money market funds, and foreign and domestic time deposits.
The Financial Services investment portfolio consists primarily of assets funded with the proceeds from the issuance of investment agreement liabilities. The investment objectives of the portfolio are to match the investment security maturity schedule to the maturity schedule of related liabilities under the investment agreements and achieve the highest after-tax net investment income. The investment portfolio is subject to internal investment guidelines, which are approved by Ambac’s Board of Directors. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits.
The following table provides the ratings distribution of the Financial Services investment portfolio at June 30, 2003 and December 31, 2002:
30
90
88
Includes U.S. Treasury and agency obligations, which comprised approximately 37% and 44% of the Financial Services investment portfolio as of June 30, 2003 and December 31, 2002, respectively.
Approximately 53% and 59% of the mortgage and asset-backed securities in the Financial Services portfolio is composed of securities issued by various U.S. government agencies, as of June 30, 2003 and December 31, 2002, respectively.
Special Purpose Entities. Ambac has transferred third-party debt obligations to two special purpose entities. The business purpose of these entities is to provide some of our financial guarantee clients with funding for their debt obligations. These special purpose entities meet the characteristics of Qualifying Special Purpose Entities (“QSPEs”) in accordance with Statement of Financial Accounting Standards 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. The QSPEs are not consolidated in Ambac’s consolidated financial statements. The QSPEs are legal entities that are demonstrably distinct from Ambac. Ambac, its affiliates or its agents cannot unilaterally dissolve the QSPEs. The QSPEs permitted activities are limited to (i) purchasing assets from Ambac, which are defined in the governing documents of the QSPEs, (ii) issuing Medium Term Notes (“MTNs”) to fund such purchase, (iii) executing derivative hedges and (iv) providing related administrative services. The QSPEs hold only passive debt obligations transferred to it by Ambac, passive derivative financial instruments used for hedging purposes and cash collected from assets that it holds pending distribution to the MTN holders. The legal documents that established the QSPEs or created the beneficial interests in the transferred assets do not permit the sale or other disposal of the transferred financial assets except for disposals in automatic response to the terms of such financial assets (this would include only issuer call provisions). These required disposals are outside the control of Ambac, its affiliates and the QSPEs. Beneficial interest holders do not have the right to put their beneficial interest back to the QSPEs.
As of June 30, 2003, there have been 12 individual transactions processed through the QSPEs, of which 8 remain. In each case, Ambac sells fixed income debt obligations issued by third parties to the QSPEs. Ambac receives cash consideration for all assets transferred to the QSPEs. Ambac surrenders control over the transferred debt obligations. There are no agreements that entitle or obligate Ambac to repurchase or redeem assets. The QSPEs are structured as bankruptcy remote entities. Ambac management believes that the assets transferred represent a true sale and the assets held by the QSPEs are beyond the reach of Ambac and its creditors, even in bankruptcy or other receivership. Legal counsel has concurred with management’s belief and has provided Ambac true sale and non-substantive consolidation opinions. The purchase by the QSPEs is financed through the issuance of MTNs, which are collateralized by the purchased assets. Derivative contracts may be used for hedging purposes only. Derivative hedges are established at the time MTNs are issued to purchase debt obligations. Ambac Assurance may issue a financial guarantee insurance policy on the assets sold, the MTNs
issued and the derivative contracts used. As of June 30, 2003, Ambac Assurance had financial guarantee insurance policies issued for all assets owned, MTNs issued and derivative contracts used by the QSPEs.
Pursuant to the terms of Ambac Assurance’s insurance policy, insurance premiums are paid to Ambac Assurance by the QSPEs and are earned in a manner consistent with other insurance policies, over the risk period. Any losses incurred would be included in Ambac’s Consolidated Statements of Operations. Under the terms of an Administrative Agency Agreement, Ambac provides some administrative services, primarily collecting amounts due on the obligations and making interest payments on the MTNs.
Cash Flows. Net cash provided by operating activities was $508.8 million and $210.9 million during the six months ended June 30, 2003 and 2002, respectively. These cash flows were primarily provided by Financial Guarantee operations.
Net cash provided by financing activities was $64.4 million and $888.3 million during the six months ended June 30, 2003 and 2002, respectively. Financing activities for the six months ended June 30, 2003 included ($106.6) million in net investment and payment agreement draws (net of investment and payment agreement issued). Financing activities for the six months ended June 30, 2003 also included the proceeds from the issuance of debentures of $363.2 million. Financing activities for the six months ended June 30, 2002 included $903.5 million in net investment and payments agreements issued (net of investment and payment agreement draws).
Net cash used in investing activities was $572.0 million during the six months ended June 30, 2003, of which $3,849.5 million was used to purchase bonds, partially offset by the proceeds from sales and maturities of bonds of $3,175.0 million. For the six months ended June 30, 2002, $1,138.6 million was used in investing activities, of which $3,167.6 million was used to purchase bonds, partially offset by the proceeds and maturities of bonds of $1,869.9 million.
Total cash provided by (used in) operating, investing and financing activities was $1.2 million and $(39.4) million during the six months ended June 30, 2003 and 2002, respectively.
Material Commitments. Ambac has made no commitments for material capital expenditures within the next twelve months.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
In the ordinary course of business, Ambac, through its affiliates, manages a variety of risks, principally credit, market, liquidity, operational, and legal. These risks are identified, measured and monitored through a variety of control mechanisms that are in place at different levels throughout the organization.
Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of Ambac’s financial instruments are interest rate risk, basis risk (e.g. taxable interest rates relative to tax-exempt interest rates, discussed below) and credit spread risk. Senior managers in Ambac’s Risk Analysis and Reporting group are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Ambac utilizes various systems, models and stress test scenarios to monitor and manage market risk. This process includes frequent analyses of parallel and non-parallel shifts in the yield curve, “Value-at-Risk” (“VaR”) and changes in credit spreads. These models include estimates made by management, which utilize current and historical market information. The valuation results from these models could differ materially from amounts that would actually be realized in the market.
Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities, investment agreement liabilities, debentures, and certain derivative contracts (primarily interest rate swaps and futures) used for hedging purposes.
Financial instruments that may be adversely affected by changes in basis include Ambac’s municipal interest rate swap portfolio. Ambac, through its affiliate Ambac Financial Services, L.P., is a provider of interest rate swaps to states, municipalities and their authorities and other entities in connection with their financings. Ambac Financial Services L.P. manages its business with the goal of being market neutral to changes in overall interest rates, while seeking to profit from retaining some basis risk. If actual or projected tax-exempt interest rates change in relation to taxable interest rates, Ambac will experience a mark-to-market gain or loss. Most municipal interest rate swaps transacted by Ambac Financial Services contain provisions that are designed to protect Ambac against certain forms of tax reform, thus mitigating its basis risk. The estimation of potential losses arising from adverse changes in market relationships, known as VaR, is a key element in management’s monitoring of basis risk for the municipal interest rate swap portfolio. Ambac has developed a VaR methodology to estimate potential losses over a specified holding period and based on certain probabilistic assessments. Ambac’s methodology estimates VaR using a 300-day historical “look back” period. This means that changes in market values are simulated using market inputs from the past 300 days. Ambac supplements its VaR methodology, which is a good risk management tool in normal markets, by performing rigorous stress testing to measure the potential for losses in abnormally volatile markets. The stress tests include (i) parallel and non-parallel shifts in the yield curve and (ii) immediate changes in normal basis relationships, such as those between taxable and tax-exempt markets.
Financial instruments that may be adversely affected by changes in credit spreads include Ambac’s outstanding structured credit derivative contracts. Ambac, through its affiliate, Ambac Credit Products, enters into structured credit derivative contracts. These contracts require Ambac Credit Products to make payments upon the occurrence of certain defined credit events relating to underlying obligations (generally a fixed income obligation). If credit spreads of the underlying obligations change, the market value of the related structured credit derivative changes. As such, Ambac Credit Products could experience mark-to-market gains or losses.
Item 3. Quantitative and Qualitative Disclosures About Market Risk (Continued)
Market liquidity could also impact valuations. Changes in credit spreads are generally caused by changes in the market’s perception of the credit quality of the underlying obligations. Ambac Credit Products’ structures its contracts with partial hedges from various financial institutions or with first loss protection. Such structuring mitigates Ambac Credit Products’ risk of loss and reduces the price volatility of these financial instruments. Personnel in Ambac’s Structured Finance Surveillance group monitor credit spread risk. Additionally, management models the potential impact of credit spread changes on the value of its contracts.
Other financial instruments that may be adversely affected by changes in credit spreads include certain total return swap contracts, which are entered into by Ambac through its affiliate, Ambac Capital Services. These contracts require Ambac Capital Services to pay a specified spread in excess of LIBOR in exchange for receiving the total return of an underlying fixed income obligation over a specified period of time. If credit spreads of the underlying obligations change, the market value of the related total return swaps changes and Ambac Capital Services could experience mark-to-market gains or losses.
Item 4. Controls and Procedures
(a) Disclosure Controls and Procedures. Ambac’s management, with the participation of Ambac’s Chief Executive Officer and Ambac’s Chief Financial Officer, has evaluated the effectiveness of Ambac’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, Ambac’s Chief Executive Officer and Ambac’s Chief Financial Officer have concluded that, as of the end of such period, Ambac’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Ambac in the reports that it files or submits under the Exchange Act.
(b) Internal Control Over Financial Reporting. There have not been any changes in Ambac’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, Ambac’s internal control over financial reporting.
PART II – OTHER INFORMATION
Items 1, 2, 3, and 5 are omitted either because they are inapplicable or because the answer to such question is negative.
Item 4 – Submission of Matters to a Vote of Security Holders
The following matters were voted upon at the Annual Meeting of Stockholders of the Company held on May 6, 2003, and received the votes set forth below:
Proposal 1. The following directors were elected to serve on Ambac’s Board of Directors:
Number of Votes Cast
For
Withheld
Phillip B. Lassiter
88,565,950
2,134,550
Michael A. Callen
88,991,919
1,708,581
Renso L. Caporali
88,941,369
1,759,131
Jill M. Considine
88,934,902
1,765,598
Richard Dulude
88,941,067
1,759,433
Robert J. Genader
89,716,110
984,390
W. Grant Gregory
88,990,260
1,710,240
Laura S. Unger
88,928,019
1,772,481
There were no broker non-votes for this proposal.
Proposal 2. The proposal to ratify the amendment to the Ambac 1997 Equity Plan was adopted, with 70,078,323 votes in favor, 11,164,117 votes against and 799,158 votes abstaining. There were 8,658,902 broker non-votes for this proposal.
Proposal 3. The proposal to ratify the selection of KPMG LLP as independent auditors of Ambac and its subsidiaries for 2003 was adopted, with 88,600,757 votes in favor, 1,518,273 votes against and 581,470 votes abstaining. There were no broker non-votes for this proposal.
Item 6 - Exhibits and Reports on Form 8-K
(a) The following are annexed as exhibits:
Exhibit Number
Description
10.31
Amendment No. 1 to Revolving Credit Agreement dated as of July 30, 2003 among Ambac and Ambac Assurance as the Borrowers, the banks, financial institutions and other institutional lenders as are or may become parties hereto, as the Lenders, The Bank of New York, as the Syndication Agent, and The Bank of Nova Scotia, as Administrative Agent for the Lenders.
31.1
Certification of CEO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
PART II - OTHER INFORMATION (Continued)
31.2
Certification of CFO Pursuant to Exchange Act Rules 13a-14 and 15d-14.
32.1
Certification of CEO Pursuant to 18 U.S.C. Section 1350.
32.2
Certification of CFO Pursuant to 18 U.S.C. Section 1350.
99.09
Ambac Assurance Corporation and Subsidiaries Consolidated Unaudited Financial Statements as of June 30, 2003 and December 31, 2002 and for the periods ended June 30, 2003 and 2002.
(b) Reports on Form 8-K:
On July 18, 2003, Ambac Financial Group, Inc. filed a Current Report on Form 8-K with its July 17, 2003 press release containing unaudited financial information and accompanying discussion for the three and six months ended June 30, 2003.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
AMBAC FINANCIAL GROUP, INC.
(Registrant)
Dated: August 14, 2003
By:
/s/ THOMAS J. GANDOLFO
Thomas J. Gandolfo
Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)
Certification of CEO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of CFO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.